Summary: Investors are clearly shifting away from actively managed funds to those based on index strategies. Only time will tell, but this has the look of a durable, secular change in investment management. But much of the perceived threat to market stability of indexing is overblown. Overall, the stock market is still dominated by active management. And while the number of index products has clearly exploded, 96% of these are of insignificant size.
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Bloomberg recently reported that the number of indexes has exploded and now exceeds the number of stocks in the US. Enlarge any chart by clicking on it.
Summary: A tailwind for the rally since February 2016 has been the bearish positioning of investors, with fund managers persistently shunning equities in exchange for holding cash.
Fund managers have become more bullish, but not excessively so. Profit expectations are near a 7-year high and global economic growth expectations are near a 2-year high. However, cash balances at funds also remains high, suggesting lingering doubts and fears.
Of note is that allocations to US equities dropped to their lowest level in 9 years in April and remain equally low in May: this is when US equities typically start to outperform. In contrast, weighting towards Europe and emerging markets have jumped to levels that strongly suggest these regions are likely to underperform.
Fund managers remain stubbornly underweight global bonds due to heightened growth and inflation expectations. Current allocations have often marked a point of capitulation where yields reverse lower and bonds outperform equities.
For the sixth month in a row, the dollar is considered the most overvalued in the past 11 years. Under similar conditions, the dollar has fallen in value in the month(s) ahead.
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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.
The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).
Let's review the highlights from the past month.
Overall: Relative to history, managers are overweight equities and very underweight bonds. Cash weightings are neutral. Within equities, the US is significantly underweight while Europe and emerging markets are significantly overweight. A pure contrarian would overweight US equities relative to Europe and emerging markets, and overweight global bonds relative to a 60-30-10 basket. Enlarge any image by clicking on it.
Summary: US equities rose for a third week in a row, to new all-time highs. Trend persistence like this normally leads to higher highs in the weeks ahead. It's true that volatility has dropped to significant lows and that volatility risk is to the upside. But timing this "mean reversion" is tricky: SPX could rise several percent before VIX pops higher. It's not a stretch to say that US equities have been focused on this weekend's French election the past several weeks; there is, therefore, a "sell the news" event risk to be on the watch out for.
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NDX and COMPQ made new all-time highs (ATH) again this week. SPX made a new ATH on a closing basis, eclipsing the prior high from March 1. The primary trend is higher.
SPX ended the week overbought (as measured by the daily RSI(5)). Upwardly trending markets are partially defined by their ability to become and stay overbought. This is a positive sign so long as it persists.
After becoming overbought, the rising 13-ema is normally the approximate first level of support on weakness. This moving average has not been touched in the past two weeks, a positive sign of trend persistence. That level is approximately 2380 (a chart on this is here).
SPX has now risen 3 weeks in a row. This is a positive sign of momentum. SPX has a strong tendency to make a higher high after rising 3 weeks in a row (blue lines in the chart below).
All of the above said, markets undulate higher. Even the most persistent trends suffer setbacks, however temporary. The current uptrend is now one of the three longest since the low in 2009; if past is prologue, a 5% correction is odds-on by the end of June. That should be the expectation of swing traders heading into summer. Read last week's post on this here. Enlarge any chart by clicking on it.
Summary: The macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely. One concern in recent months had been housing, but revised data shows housing starts breaking above the flattening level that has existed over the past two years. A resumption in growth appears to be starting. That leaves two watch outs. The first is employment growth, which has been decelerating from over 2% last year to 1.6% now. It's not alarming but it is noteworthy that expansions weaken before they end, and slowing employment growth is a sign of some weakening that bears monitoring.
The second watch out is demand growth. Real retail sales excluding gas is in a decelerating trend. In March, growth was just 2.0% after having grown at more than 4% in 2015. Personal consumption accounts for about 70% of GDP so weakening retail sales bears watching closely. Overall, the main positives from the recent data are in employment, consumption growth and housing:
Monthly employment gains have averaged 187,000 during the past year, with annual growth of 1.6% yoy. Full-time employment is leading.
Recent compensation growth is among the highest in the past 8 years: 2.6% yoy in 1Q17.
Most measures of demand show 2-3% real growth. Real personal consumption growth in 1Q17 was 2.8%. Real retail sales (including gas) grew 2.7% yoy in March.
Housing sales grew 16% yoy in March. Starts grew 9% over the past year.
The core inflation rate is ticking higher but remains near the Fed's 2% target.
The main negatives have been concentrated in the manufacturing sector (which accounts for less than 10% of employment). Note, however, that recent data shows an improvement in manufacturing:
Core durable goods growth rose 6.4% yoy in March. It was weak during the winter of 2015-16 but has slowly rebounded in recent months.
Industrial production rose 1.5% in March, helped by the rebound in mining (oil/gas extraction). The manufacturing component grew 1.0% yoy in March.
Our key message over the past 5 years has been that (a) growth is positive but slow, in the range of ~2-3% (real), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.
Modest growth should not be a surprise. This is the typical pattern in the years following a financial crisis like the one experienced in 2008-09.
This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes. Enlarge any image by clicking on it.
A valuable post on using macro data to improve trend following investment strategies can be found here.
Let's review each of these points in turn. We'll focus on four macro categories: labor market, inflation, end-demand and housing.
Employment and Wages The April non-farm payroll was 211,000 new employees minus 6,000 in revisions. In the past 12 months, the average monthly gain in employment was 187,000. Employment growth is decelerating.
Monthly NFP prints are normally volatile. Since the 1990s, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low print of 79,000 last month, 84,000 in March 2015 and 24,000 in May 2016 fit the historical pattern. This is normal, not unusual or unexpected.
Summary: S&P profits are up 22% yoy. Sales are 7.2% higher. By some measures, profit margins are at new highs. This is in stark contrast from a year ago, when profits had declined by 15% and most investors expected a recession and a new bear market to be underway.
Bearish pundits continue to repeat claims that are more than 20 years old: that "operating earnings" are deviating more than usual from GAAP measurements, and that share reductions (buybacks) are behind most EPS growth. These are both wrong. Continued growth in employment, wages and consumption tell us that corporate financial results should be improving, as they have in fact done.
Where critics have a valid point is valuation: even excluding energy, the S&P is now more highly valued than anytime outside of the 1998-2000 dot com bubble. With economic growth of 4-5% (nominal), it will likely take excessive bullishness among investors to propel S&P price appreciation at a significantly faster rate.
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A little over 60% of the companies in the S&P 500 have released their 1Q17 financial reports. The headline numbers are good. Overall sales are 7.2% higher than a year ago, the best annual rate of growth in more than 6 years. Earnings (GAAP-basis) are 22% higher than a year ago. Profit margins are back to their highs of nearly 10% first reached in 2014.
Before looking at the details of the current reports, it's worth addressing some common misconceptions regularly cited by bearish pundits.
First, are earnings reports meaningfully manipulated? This concern has been echoed by none other than the chief accountant of the SEC, who has complained about non-GAAP earnings numbers being "EBS", or "everything but bad stuff." Enlarge any image by clicking on it.